GameStop Corp. (GME) Q2 2017 Earnings Report, Transcript and Summary

Good day and welcome to GameStop's Corporation Second Quarter 2017 Earnings Conference. A supplemental slide presentation is available at investor.gamestop.com. At the conclusion of the announcement, a question-and-answer session will be conducted electronically. [Operator Instructions] I would like to remind you that this call is covered by the Safe Harbor disclosure contained in GameStop's public documents and is the property of GameStop. It is not for rebroadcast or use by any other party without the prior written consent of GameStop. At this time, I'd like to turn the call over to Mr. Paul Raines, CEO. Please go ahead, sir.

Thank you, operator and welcome to our second quarter GameStop earnings call. I want to start, as always, by thanking our associates around the world for their commitment to providing excellent customer service during this quarter. Speaking today on the call are Rob Lloyd, our CFO; and Tony Bartel, our COO. Also in the room with me today are our senior staff and they are available for questions after the scripted remarks. The second quarter played out along the lines we had expected achieving our targets. On the physical gaming front, the Switch has been a massive success, leading to our hardware growth of 14.8% for the quarter. Tony and Rob will give you details, but it has been our most successful Nintendo launch ever. Attach rates have been consistently high and are at over five to one since launch and we expect healthy allocations in the back half of the year. Our Game Trust division published Has-Been Heroes for the Switch and has also been very successful. Overall, during the quarter, we grew our software market share by 30 basis points. The Switch launch is one of the keys we have been watching all year to gauge the consumer's appetite for gaming. Based on the results so far, the consumer's appetite for gaming is healthy and we believe that all consoles have opportunities for growth. Sony has also been strong this year and we just started taking preorders for Microsoft's Xbox One X, which launches in the fall. In addition, we saw a very high demand this week for Nintendo's SNES Classic. Our digital receipts grew 17.4% this quarter, led by downloadable content growth and strong levels of full game download sales of Mario Kart 8. We continue to face pressure in pre-owned, our results were within our forecast at a minus 0.7% decline -- minus 7.5% decline, excuse me. Inventory levels, a key driver of performance in this category are stronger at plus 8% per year -- or year-over-year. So, we do expect better results in the back half of the year. Tony will share some further details on this business. As you've heard on prior calls, our PowerUp program has been an intense focus since this time last year. I am pleased to report that our paid level, which we call PowerUp Pro, is up by 1.5 million members in the last 12 months in the United States, each paying $15 per year to receive the benefits of membership. As you know, our PowerUp Rewards program, with over 50 million members worldwide, provide significant value to our most loyal customers and is a key to our success in driving pre-owned business, omnichannel businesses, and growth in Collectibles as its members represent over 70% of our sales volume. So, we know it's working. Our omnichannel sales almost doubled year-over-year, and we're using it to drive cross-platform connections like Switch sales at ThinkGeek.com or rapidly setting up a Funko POP! Vinyl club. So, we are confident we will see better growth in the U.S. at holiday this year. We will also announce a new level of the program at our upcoming Managers' Conference and our internal teams have worked hard to deliver a compelling set of upgrades for that program that will include better pre-owned and trade credit benefits, Collectibles opportunities, and shipping bundles. Now, turning to Collectibles, we had another strong quarter with 36.1% growth and good margins. We believe we have a great opportunity to grow in this fragmented industry, and we have already become the top share distributor of several brands. As you saw in our press release yesterday, we are adding Janet Bareis to our senior team as our Senior Vice President of Collectibles, reporting directly to me. This hire demonstrates our continued commitment to growing this strategic business. Janet came to us from Walmart and has over 20 years of experience in the licensing, merchandising, and store assortment of Collectibles. Janet brings us new valuable media and studio relationships. So, welcome to GameStop, Janet and you all can look forward to hearing from her on this call in the future. Moving on to Technology Brands, our team is focused on transitioning over to selling entertainment products and capitalizing on the iPhone launch. Being in the video game business for many years, we have expertise in launching new and innovative products. The investments we've made in the Technology Brands segment since 2013 position us well to participate in a new category of exciting product launches. We believe this business has great upside for us and we continue to push our own rate of change to match that of our partners, AT&T and Apple. Jason Ellis and his team have a great plan for the iPhone launch, and we believe we are taking the right steps to maximize the benefits of this launch. Remember, this business integrated a third of its current footprint one year ago and that training process takes some time, but we continue to be bullish on our results for the year in that business unit. Looking ahead, in addition to the iPhone launch, we're excited about the continued success of the Nintendo Switch, the launch of Microsoft's Xbox One X, and the solid slate of AAA titles that will drive our earnings in the back half of the year. And with that, I will turn the call over to Rob Lloyd.

Thank you, Paul. Good afternoon, everyone. Our second quarter results were driven by continued momentum from the Nintendo Switch and related software. Our allocation in Q2 was in line with our expectations and we continue to sell-through while read [ph] the allocations quickly, which drove our sales comps. Some of the quarter's highlights include consolidated sales comps of 1.9%, including down 1.4% in the U.S. and up 9.8% internationally. The U.S. showed sequential improvement over Q1. Total sales growth of 3.4%, including hardware sales up 14.8% and accessories sales up 20.6%. Growth in our Collectibles business is 36.1% to $122.5 million in sales. Margin rates in Collectibles were 35.3%, normalizing from the result in Q1. Consolidated gross margins were 37.0%, down slightly from last year due to the strong hardware growth. As we look in greater depth, we see Nintendo Switch drove the increase in hardware sales. Consumer demand continues to be strong and our hardware and software market share has continued to lead in the U.S. and in most of our markets we operate in around the world. New software sales met our expectations with the decline of 3.4%. We gained 30 basis points of software share in the quarter. The margin rates on new hardware and new software are both over 300 basis points lower than Q2 last year, due to the mix of products sold and the title slate. Pre-owned sales declined 7.5% during the quarter, within our expected range of down mid-single-digits for the full year. In both new and pre-owned, we're seeing underperformance in Xbox One versus PS4, which we believe is due to the coming Xbox One X launch. Digital receipt increased 17.4% and GAAP digital revenues grew 28.1%, due to strong sales of Injustice 2, Mario Kart, and mobile games. Tech Brands' revenue grew 7.0% and continue to be impacted by the slowdown in the wireless upgrade cycle, event as the new iPhone launch and by AT&T's changes in the underlying compensation programs. As we have discussed, compensation program changes are designed to pivot our sales efforts to emphasize entertainment products and services. Tony will share some statistics on our success driving more DIRECTV sales and other initiatives. The traffic comp was down 8.9%, a slight decrease from down 7.3% in Q1, while the gross profit comp was down 13.3%, reflecting an improvement from Q1, due to our efforts in driving both B2B and DIRECTV products. Tech Brands' gross margin was 73.8%, up from 62.9% in Q2 of last year as the AT&T business is now a larger percentage of the total Tech Brands' business. Tech Brands' adjusted operating earnings were $15.0 million compared to $13.9 million in Q2 of last year. SG&A was $542.4 million in the quarter, up 4.6% from Q2 of last year, due to the growth in Tech Brands' store count. We sold our Kongregate division with the transaction closing in mid-July. Kongregate was seeking funding to publish games at a greater level than we were willing to invest, given historical profitability and return levels. With recent successes like Animation Throwdown, we capitalized on the opportunity to sell it now. The sale resulted in a gain of $7.3 million, also $7.3 million net of tax or $0.07 per share. Consolidated operating earnings for the quarter were $43.6 million. Consolidated adjusted operating earnings were $36.3 million, excluding the gains from the sale of Kongregate. Operating earnings compared to last year were impacted by declines in software and pre-owned sales and in the margin rates of new hardware and new software. Our effective tax rate on an adjusted net income before tax basis was 32%. GAAP earnings per share were $0.22 and adjusted earnings per share were $0.15. Consistent with the strategic plan we communicated to you last year, we closed a net of 28 video game stores to now have 3,881 in the U.S. and 1,991 internationally. We opened one net Tech Brands store and now have 1,509. We opened five Collectibles stores in the quarter and now have 99 worldwide. Now, I'll move on to third quarter commentary. Hardware in Q3 will again be driven by the allocation of and demand for Nintendo Switch, although we are up against the Slim launches from last year. New software sales are expected to increase 5% to 10% with strong AAA titles like Destiny 2, Assassin's Creed, and Gran Turismo coming in the quarter. Collectible sales are expected to grow 30% to 40%, again, from the $109 million in sales in last year's third quarter, and we are on-track to meet our full year sales target of $650 million to $700 million in that business. For the full year, we are maintaining our annual guidance of $120 million in operating earnings from Tech Brands. Our full year guidance includes the launch of the new iPhone during the third quarter, which we modeled based on the average of the last three iPhone launches. Given what we've seen so far in hardware growth, full year same-store sales are trending to the high end of our guidance range of negative 5% to flat. For the full year, we are maintaining our current EPS range of $3.10 to $3.40. I'll now turn it over to Tony.

Thanks Rob. We moved back to topline growth in quarter two as strong hardware and Collectibles sales drove our GameStop branded stores, our omnichannel sales nearly doubled, and our Technology Brands stores exceeded last year's profit numbers. In the U.S. GameStop branded stores, market-leading Switch sales fueled our hardware growth. While we had the largest Switch market share of any retailer, we were again allocated below our normal market share, resulting in lower hardware market share for the quarter. We continue to see strong demand for the Switch and sell out our inventory in a matter of days of it being available in our stores and our websites. We believe that this will continue through the holiday. We continue to drive strong software and accessory attached to Switch units, attach units twice the rate of our competition. This means that we are far more profitable on the units that we are allocated. We are selling Switches in our stores and in both GameStop.com and ThinkGeek.com, where we are offering unique Collectible bundles. We grew software share during the second quarter as we capitalized on key title launches and drove attach to the Switch. We are excited about the title slate ahead of us and believe that we will see software growth in the back half of the year. A key barometer of our future success is the growth in game preorders and we're currently seeing a 19% increase in overall preorders versus this same time last year. We also just started taking preorders on the Xbox One X this week. And while it's still early, we are pleased with the initial consumer response to this powerful new console. We are excited that customers will be able to get hands-on experience with this console at our Consumer Expo in Las Vegas this weekend. Our pre-owned sales lagged software sales by four points due to strong new Switch software sales. To put the impact of Switch into perspective, our pre-owned growth would have outpaced new software growth by 10 points, if Switch sales were removed from both categories. Our pre-owned inventory is in a very good position as we have 8% more inventory per store than we did a year ago. In addition, we are seeing significant trade activity in mobile devices. Pre-owned mobile sales grew 36% during the quarter and we were still able to add inventory. So, we are in a very strong position for additional growth. As a reminder, we will have rolled out technology prior to the new phone launches in most of our GameStop branded stores that allow consumers to safely and quickly trade-in their phones. Another bright spot was our omnichannel growth which grew 86% during the quarter. While this growth was partially fueled by popular Switch bundles, we were also aided by the addition of buy online, ship to store during the quarter. Our fastest-growing omnichannel revenue stream is our Web In-store program which grew 460% during the quarter as we offered customers an endless aisle of products from GameStop.com, ThinkGeek.com and from other suppliers. Our PowerUp Rewards program continues to be a strength of the company. Since last year, we have increased our paid Pro membership tier by 1.5 million members. Our PowerUp Pros are our very best customers, spending three times that of our basic members. They are not only our most frequent customers, they are also our most savvy and they activate the full benefits of our buy-sell-trade model to get the most gaming for the best value. Turning to Collectibles, we had a very strong quarter as we grew 36%. We continue to expand linear footage in our GameStop branded stores and we'll continue to evaluate the linear footage in our stores to maximize traffic and profitability. We believe that the overall Collectibles market will surpass the video game market as soon as next year. We added five dedicated Collectibles stores during the quarter, bringing our global dedicated store count to 99 stores. Similar to video games, we have quickly become the world leader in several key Collectible categories by leveraging our large store base, our buy-sell-trade model, the close association to video games, and of course, our powerful PowerUp Rewards loyalty program. As an example, we currently sell more of the popular POP! Vinyl characters than anyone else in the world. One half of our loyalty customers who purchase Collectibles and they spend more money annually on Collectibles than they do on video games. We are on track to achieve both our annual Collectibles goal and our strategic revenue goal of $1 billion by 2019. We also expanded PowerUp Rewards into the Collectibles space with the launch of our Funko Insider Club, which provides exclusive benefits to our most loyal collectible customers. This is an example of how we will continue to evolve our PowerUp Rewards program to offer new and better ways to engage with our best customers. Before we turn to our Technology Brands business, I do want to mention that we will be open on Thanksgiving this year in our GameStop branded stores. We carefully weigh the impacted on our associates with the demands of the changing retail environment and the shopping preferences of our customers. And we've made the decision to open and defend our market share position during what has become a major shopping day. Turning to Technology Brands, we slightly exceeded last year's profits as we continue to evolve our business to meet AT&T's key priorities. Our comp store traffic declined 9% and our comp store gross profit declined 13%. For the second quarter, revenue and gross profit were pressured by lower wireless upgrade commissions combined with a slower than expected upgrade cycle. Our plan for the year was to increase overall sales of the entertainment products, specifically DIRECTV and DIRECTV NOW. While we have seen 348% growth in the entertainment of business categories, it's not been enough to overcome the slow upgrade cycle. As we discussed on our last call, this is a macro trend which we anticipate will turn in our favor with the upcoming iPhone launch. Starting in August, we will begin to comp the 425 stores that we acquired last year. And based on the 15% increase in productivity that we are seeing in these stores, we expect that to help drive both traffic and gross profit comps going forward. AT&T has remained steadfast in its focus on sales of entertainment and business solutions. At the beginning of the year, we launched business centers in all of our AT&T branded retail stores. These business centers, combined with the growth of an outside of business sales team, has created the largest business footprint for AT&T in its retail distribution channels. We've also continued to develop our training and sales skills around selling entertainment products in retail. The category, which includes both DIRECTV and DIRECTV NOW subscribers, experienced 238% growth in our stores. We have many of our locations that have found tremendous success in selling bundled TV and entertainment products in high volume. We believe these bundles offer excellent value to customers and we have plans in place to inform customers and replicating higher sales volumes across all locations throughout the remainder of the year. We are already AT&T's largest seller of entertainment products and we expect to widen that gap. We have a strong partnership with AT&T and are in alignment with their strategy and believe it will create additional opportunities for us to partner and grow in the future. As we look at the remaining portion of the year, it is clear that we are relying on high consumer demand for both the Samsung Note and Apple iPhone. iPhone will carry the most weight and we have several data points that would suggest this will be a significant iPhone launch. The first is that according to Forbes, over 82% of the installed base in the U.S. has an iPhone 6s or older, so there's dated hardware in the market. As previously noted, we have seen a steeper than usual decline in upgrades during the first half of the year. So, many customers with older devices are eligible to upgrade. It is also been our experience that form factor changes have historically driven high demand as the biggest launch in our history was the launch of the iPhone 6. While still speculative at this point, most of the rumors would indicate a significant form factor change for the upcoming iPhone release. So, as you can see, the year is shaping up as we expected. We are optimistic that the innovation in both video games and phones, coupled with the investments that we have made in PowerUp Rewards and in training will yield solid results in the back half of the year. I'll now turn the call back over to Paul.

Thank you, Tony. And operator, let's open it up for questions and answers.

Thank you. [Operator Instructions] And we'll take our first question from Colin Sebastian with Robert Baird. Please go ahead.

Thanks guys. I have a couple of questions. First off, Tony, I think you mentioned the increase in preorders year-over-year. And I was wondering if that's reflective only of the increasing interest in the video game release slate or is that also the result of specific merchandising actions that you've taken in the stores? And then maybe for Rob, perhaps a little more detail on the pre-owned segment margins which were below your guidance range and what's along with that. Perhaps, what impacts, on the Digital segment performance should we expect from the sale of Kongregate? Thank you.

Tony?

Sure. There is definite demand for the games and we are seeing, Colin, it is positive. But there are several things that we're doing in the stores. For instance, the 1.5 million PowerUp Reward members that we added, those are very active. It gives us a chance to have a deeper engagement with them, so we're leveraging now to drive preorders. We also have a renewed effort around the exclusive content that we are providing and that is also shifting share in our directions in the preorders. And finally, similar to what we did last year in terms of driving PowerUp Rewards paid tier customers, we're doing the same thing with preorders in our stores and its working. So, it's a major focus for us. And so not only is our great interest in games, but we also believe that we're shifting share.

Colin, with respect to the pre-owned, we had a 45.0% margin in the quarter which is consistent with what we did in the second quarter of last year and consistent with what I typically state as the range of 45% to 48%. There has been some confusion as to whether or not that's 46% to 49%, but it should be 45% to 48%. And I will say in this particular quarter, one of the things that drove our increase in pre-owned inventory has been some PS4 promotions that we've done internationally. So, I think, as Paul and Tony stated, it sets us up pretty well with inventory for the back half of the year.

And then the Kongregate impact on the Digital business?

Digital revenues?

Yes.

That would be, I would say, less than 5% of our digital gross receipts.

Yes, we should emphasize again that the Kongregate sales is not an issue of us not performing well. There is an issue of that team wants to invest heavier in that business segment, which is probably for them the right thing to do. We just have other places we want to dedicate capital. So, we part as friends and we also have a relationship now with a premier eSports company and marketing company in the Nordic countries, so that's going to give us some opportunities down the road.

Okay. Thanks guys.

Thank you, Colin.

Thank you. We'll now take our next question from David Magee with SunTrust.

Yes, hi. Good afternoon everybody.

Hey David.

A couple of questions. One is the -- just to make sure I understand this correctly, the pre-owned inventory being up 8% right now year-to-year, did I hear that correctly?

Yes.

And is that enough to produce a positive comp for that business in the second half of the year?

At this point, David, we're sticking with our mid-single-digits down guidance that we gave at the beginning of the year.

Okay. The -- how do you all feel about the titles at the holiday time now? It sounds pretty good on the third quarter. I'm curious if you look beyond the third quarter. What is your current feeling at this point?

We're very optimistic about that, David. And that is indicative of the -- I mean, the 19% increase in preorders is not just for Q3, but that's for all the titles that are coming in the back half of the year. But we feel very good about Assassin's Creed and World War II and we've got Super Mario coming out as well. So, there's a lot of great titles that are ahead of us, not just those in Q3, but we feel very good about the title line up. And it should be noted that again, at our Expo, there's going to be lots of customers that see these games as well as our managers that once again, this next week, going to get a behind-the-scenes look at all of the great games that we have. So, we will again have the most educated salesforce in the video game industry.

I think it's also worth saying, Dave, that last year, we were surprised by some of the predatory discounting that we saw from our competitors. I think this year, Tony and Bob Puzon and team, have done more scenario planning than I've ever seen us do, and I think we're more prepared for that than ever. So, it should be good.

Thank you, Paul. And then lastly, if you look at the Tech Brands store -- the mobile stores, what percent of business right now would you say is the entertainment product part of the business as opposed to mobile phones?

We haven't disclosed that. We tend to follow AT&T's lead on these kinds of statistical disclosures. And to the best of my knowledge, I think I read their transcripts, I don't recall that they disclosed that.

Okay. Fair enough. Thank you, Rob.

Thank you. We'll now take our next question from Brian Nagel with Oppenheimer.

Hi, good afternoon. Thanks for taking my questions. So, I have two questions. One on the video game business and one on the Tech Brands. So, I'll ask the video gaming question first. As we look at pre-owned, which has been soft now, consistent with your guidance, you made a comment about the better inventory position which should help lever this year. But as we look out further, how do you think about that business? And are there other levers that you can pull to help sort of as they jump start better demand as we look out -- and I guess that's question one.

Yes, I think you know, Brian and -- I'll let Tony jump in here -- Mike Mauler. But I think we've been challenged to grow that business in a declining software cycle that we've been in. I think if you look at Tony's numbers though, without the Switch, we would've had--

10%.

Relatively better performance compared to the next-gen. There's a lot of things going on in the pre-owned business to try to get better results. Maybe, Tony, you want to?

Yes and I do see this is a timing issue too that we do lag the new business and so we do have a lot of that Switch. We are certain that a lot of Switch new right now which is helping to offset some declines in Xbox One, as Rob talked about and give us a better number on the software side. But that inventory is not coming back. Yes, I mean, it's coming back in typical form, we just haven't seen it yet. So, I think as that inventory continues to come back, you'll begin to see our comps increase as well.

The other question is, what are we going to do? I mean, if you look beyond just beyond the pre-owned, what are we going to do to keep driving our gross margin rate? And that's where the Collectibles is playing a role as is technology. We’ve hit some bumps in the road on some of those, but I think you'll see we're trying to drive a higher rate of gross margin growth because we expected that pre-owned would be under pressure through this cycle.

Got it. The second question I have on Tech Brands. You talked about the launch of the new Apple phone. How should we think about -- what potential lift that you give? Is there something, if you look back at the history of that the division with other launches? And then second to that is to what extent is any lift in the guidance you provided?

Jason Ellis is here. Why don't we -- Jason, you want to take that question?

Yes. Let me give you some color on that, Brian. We've looked obviously at the last four years of iPhone launches and really modeled the last three and we have lots of data around unit sales by store. And in the guidance that Rob has given, we've just averaged the last three cycles. And so we have put a lot of time and energy into that and that's in the guidance that we've given.

So, I would say, Brian, this is Rob, that there are probably some publicly available statistics out there on what kind of volumes the iPhone launch drove in those years that Jason was talking about that you could look at.

You could almost say, guys, that in spite of our -- we've had some headwinds in the first six months of this year in that business. But you could almost say the size of this launch, if you do the research, Jason, you were telling me earlier, how big this thing could be for the industry worldwide?

Yes. Several hundred million units.

It's a massive event for the industry. So, our positioning to be in this business for this launch, you could almost argue, that's a tremendous rationale for being in the AT&T business.

Well, thank you. Good luck,

Thanks.

Thanks Brian.

Thank you. [Operator Instructions] We'll take our next question from Curtis Nagle with Bank of America-Merrill Lynch.

Great. Thanks very much for taking the question. Just going quickly back to the gross margin. Rob, if you don't mind, could you just go into a little more detail on what specifically were the issues with mix or the hardware and the software businesses that hurt the GM? If you can provide any color that would be great.

Yes, the different manufacturers and the different publishers have different margin rates with respect to their products. They don't differ by a lot, but they do differ a little bit. So, the mix of whose units you're selling can impact with you in the quarter. The slate impact, what you do in the quarter, particularly as it pertains to the marketing dollars that we are able to get to drive the title sales and those marketing dollars have an impact as well on what the margin rates are for the categories.

Okay. And then just a quick follow-up. So, understanding that you still got a pretty big chunk of business ahead of you. But given how strong your hardware numbers are to date, just kind of curious why you wouldn't update the, at least, the range for your hardware forecast this year, given what Switch has done and given that you think you're going to get better allocations?

Well, one of the things that we see and I mentioned it in my remarks was that in the third quarter, we're up against the Xbox Slim launch and the PS4 Slim launches from last year's third quarter. So, those are pretty strong. As I mentioned, we have some insight into what our allocation is with Nintendo. And so when we dig into the details and look at it, those things are factors that certainly affect the third quarter. We are pleased with the market leading allocations we're getting on Switch. We want to see that demand continue into the fourth. We recognize also that we've had some difficulty in the last couple of third quarters and we want to make sure that we are able to deliver on the numbers.

I think if I can add to Rob's comment, the last thing in the world you want is for us to promise things we don't deliver. We've done quite a bit of investor surveys and that's the feedback we get. So, I think we've been accused of being conservative in some ways. I would say this industry is difficult enough to forecast as you all know that we have to be cautious on our outlook.

Okay, fair enough. Thanks very much for the answers on that.

Okay. Thank you, Curtis. With that, operator, I think we will wrap-up the call. I want to thank everyone for being on the call today and we will -- thank you for your support at GameStop and we look forward to seeing you next week at our Manager's Conference for those of you who will attend. Thanks.

Thank you. And that does conclude today's conference. Thank you all for your participation.